1. The theory of absolute and comparative advantages
1.1 Adam Smith and absolute advantages
Adam Smith was a Scottish economist and philosopher who was born in 1723. During his working years, the economy was in the age of colonial type international division of labour. The main features of this age were the well-organized foreign traded and financial processes. The emperors exploited their colonies and wanted to increase the volume of export in order to get more and more surplus from international trade. Beside of the increasing volume of foreign trade, economies got another impulse. This impulse was the first industrial revolution. Finally, this is the age of classical capitalism and Adam Smith was the one who posed its principles.
In this period, the condition of production varied or was different from country to country. Based on differences countries shared their production and produced only those products in which they had absolute advantages compared to the other countries. This was and still is the main principle of division of labour. (However, in Adam Smith’s time this concept was not used, Emile Durkheim was the one who used this phrase but in another sense). According to Adam Smith, countries trade with each other because they are different from each other and want to achieve economies of scale in production. If each country produces only a limited range of goods, it can produce each of these goods at a larger scale and hence more efficiently than if it tries to produce everything by itself. Nowadays, this kind of trade appears among brands and less among different types of goods. In order to be able to explain absolute advantages, we have to pose some conditions. In this model, we have two countries (I and II), two products (X and Y) and only one factor of production
3 which is labour. The two countries have different production conditions. If the I. country can produce X products on a lower cost per unit, while the II. country can produce Y products on a lower cost per unit, than I. country has absolute advantage in the X production and II. country has absolute advantage in the Y production. Therefore, first country has to give up the production of Y products (even one unit of Y product is not efficient, but in our models efficiency is important), second country has to give up the production of X products, so first country will produce only X products, while second country will produce only Y products after they finished the specialization.
We can explain the process with functions as well, but first some phrases have to be clear up:
production curve/production possibility frontier: the curve represents graphically alternative production possibilities between two products when there is a fixed amount or availability of resources. The curve represents the point at which an economy is the most efficient.
linear production curve: opportunity costs are constant
bulging downward curve: opportunity costs are increasing
opportunity cost (alternative): the cost of choosing between alternatives, it represents the benefit an economy missed out on when choosing one alternative over another.
First figure represents the constant; the second figure represents the increasing opportunity cost. In case of linear transformation curve, you always have to give up the same number of Y products in order to produce one unit of additional X product. According to the figure, you have to give up 20 Y products in order to produce additional 20 X products. Which means that in this example the opportunity cost is 1. If you have increasing opportunity cost, you have to give up a greater number of Y products in order to produce one
4 unit of addition X product. According to the figure, you have to give up approx.
5 Y in order to get 20 X, but if you want to get 20 more X you have to give up 10 more Y and so on.
1. Figure: Production possibility frontier/transformation curve/production curve
Source: Bock et. al., 1991.
The reason for increasing alternative cost can be the specific factors of production. At the first phase of specialization, countries redistribute easily mobilizable factors but after we finished their redistribution we should mobilize our specific factors as well, but we cannot reach as much output as before or better to say our losses will increase. Determination of opportunity cost is not as easy an in case of linear production curve. We have to introduce a new phase, which is the marginal rate of transformation (MRT). Marginal rate of transformation shows that how many units of one product have to be reduced in order to increase the production of the other product at a given point of production curve. Marginal rate of transformation is equal with alternative cost:
marginal alternative cost of X product:
marginal alternative cots of Y product:
5 1.2 DAVID RICARDO AND COMPARATIVE ADVANTAGES
David Ricardo developed or better to say published this theory in 1817.
Comparative advantages theory offered a solution for a problem that arose after Adam Smith introduced absolute advantages. The problem was that many countries traded with each other despite of the fact that one of them can produce every single good more efficient than the other one, so according to Smith’s theory there was no reason for their trade. David Ricardo discovered that the answer is in their opportunity costs. Until the opportunity cost is not the same in two countries, they have reason for trade. A classic example is Portugal wine and English cloth. Portugal has absolute advantage in wine and cloth production as well, but in a different scale. As you can see in the first table, 1.5 times more working hour required UK to produce one unit of wine and 1.1 times more working hour for cloth. With other words, Portugal needs fewer working hour for production of wine and cloth; it can produce more products during the same period. According to Ricardo’s theory, there is still opportunity for trade. Because of the difference is larger in case of wine than cloth therefore, Portugal should specialize for wine and United Kingdom should specialize for cloth. United Kingdom has namely comparative advantages in cloth and comparative disadvantages in wine, while Portugal has comparative advantages in wine and disadvantages in cloth.
1. Table: Example for Ricardo’s comparative advantages
working hour required
6 The existence of comparative advantages does not mean that countries can or want to utilize them. Really good example for this is when countries have to face with some trade barriers like quotas, customs or any other similar restrictions. But if we do not have to struggle with any kind of trade barriers, in a perfect market, market mechanisms lead to the redistribution of production factors, so specialization. Ricardo’s theory gives also explanation how mutually beneficial trade can be between or among countries with different level of development.
1.3 SPECIALIZATION AND FOREIGN TRADE IN CASE OF CONSTANT OPPORTUNITY COST
Assuming that there are two countries, which start to trade with each other, and both of them have constant opportunity cost (PPF line is linear) we can draw the following model:
2. Figure. Specialization and foreign trade in case of constant opportunity cost.
Source: Bock et. al., 1991.
7 I. country has better conditions in the production of X product; the opportunity cost of one X product is approx. ⅓ Y products. From the aspect of Y product, its opportunity cost is three X products. So, the inner terms of trade before foreign trade: 1 X = ⅓ Y in the I. country.
In the second country, we can see the opposite. II. country has better conditions in the production of Y product, the opportunity cost of one Y product is approx. ⅓ X product, from the aspect of X product, its opportunity cost is 3Y products. So, the inner terms of trade before foreign trade: 1 X = 3Y.
For the II. country is better to import X product from I. country and should specialize only for Y product and export it to the I. country. For the I.
country is better to import Y product from II. country and should specialize only for X product and sell it to the II. county. On the 2nd figure A and B points represent the autarch (before trade) production and consumption point.
Production and consumption point must be the same in case of self-sufficiency because citizens can consume as much as their economy produces. After the two countries start to trade with each other and change their economic structure (so starts to specialize), production point and consumption point will not have to be the same. Because of constant opportunity cost, specialization is absolutely complete, the new production points are A’ and B’ and the new consumption point is E. If we project these points to X and Y axes, we can get a triangle in each country. This triangle is the foreign trade triangle. One leg/cathetus represents export, the other one represents import.
After these two countries started to trade with each other and finished specialization the new terms of trade in both country (according to our example) is 1X = 1Y. In our model only these two countries are, therefore, the international terms of trade is equal with theirs. If international terms of trade is among the self-supporting terms of trade both country can enjoy the advantages of foreign trade. Consumption point is the part of consumption line
8 which slope also represents the terms of trade not just the national but also international terms of trade.
1.4 WORLD TRANSFORMATION/PRODUCTION CURVE IN CASE OF CONSTANT OPPORTUNITY COSTS
In order to be able to demonstrate the advantages of specialization from production side, production aspect, we need to adopt a new means, the world transformation curve/world production possibility frontier. The model of world usually contains two countries, but there are opportunities to make models which deduce the world transformation curve of more countries. World transformation curve or production possibility frontier represents the total amount of products, which can be produced with available input within the world. The figure represents this curve if opportunity cost is constant and if there are just 2 countries in the world. The area marked with I. represents the set of first country’s production opportunities (production block). The area marked with II. represents the production block of second country. Hypotenuse of triangles gives world production possibility frontier (FG + GH). The maximum production of Y product is represented by OF stage, while the maximum production of X product is represented by OH stage. OM and ON stages are produced by II. country, MF and NH stages are produced by I.
country. Until the two countries do not trade with each other and do not specialize their economies the inner production and consumption points are A and B, and these two points give together the world production point in autarchy. B point is under the world’s production possibility frontier therefore it is suboptimal. After countries transform the structure of their economies and finish specialization (which based on absolute or at least comparative advantages) world production point moves from B to G point and gets to the FH stage, which represents optimal level. According to absolute (and
9 comparative) advantages, specialization increases the efficiency of production which can lead to increasing welfare as well. In a later chapter we explain this process in detail.
3. Figure. World tranformation curve – Constatnt opportunity costs Source: Bock et. al., 1991.
1.5 SPECIALIZATION AND FOREIGN TRADE IN CASE OF INCREASING OPPORTUNITY COST
If we suppose that opportunity cost is increasing in both countries, then production possibility frontier is concave to origin therefore, the determination of price ration (slope of the curve) is a bit more difficult because in each point the slope is different. The specialization will not be complete. The difference between marginal rates of transformation depends not only on different production conditions but also on differences in demand factors, but it is not important for us now. The trading and specialization process is quite the same, but now as we have already mentioned, specialization cannot be complete therefore A’ and B’ points are not on axes. So, first country still produces Y product (after specialization) and second country produces X product but of course less. In self-sufficiency, MRT is ¼ in I. country and 4 in II. country. If
10 MRT is different countries have opportunity to trade with each other and specialize their economies to produce X or Y product.
4. Figure. Specialization and foreign trade in case of increasing opportunity costs.
Source: Bock et. al., 1991.
After specialization, following equation must be fulfilled:
The opportunity of free international trade consolidates internal terms of trade in both countries because they increase trade volume until the utilization of international price differences makes extra-profit possible.
Moreover, in order to fulfil one of the main principles of perfect market, so prices stay equal with the marginal cost, the factors of production must be relocated. Consequently, the impact of market forces results in the changes of production points (from A to A’ and from B to B’). In the new points, we can say that countries absolutely utilized the potential advantages of the originally different price ratio.
11 If we further assume that the new consumption points will be in E point, than we can draw again a foreign trade triangle. One cathetus represents export volume that is equal with the other one that represents import volume
1.6 WORLD TRANSFORMATION/PRODUCTION CURVE IN CASE OF INCREASING OPPORTUNITY COSTS
Editing a world transformation curve when we have increasing opportunity cost is a little bit more difficult because of the concave nature of production possibility frontiers. We cannot just simply put the first production block on the second one. The figure represents how we can get it.
5. Figure. World transofrmation curve – Increasing opportunity costs Source: Bock et. al., 1991.
As you can see in the figure, now we have to fit the two production blocks based on their self-supporting production and consumption point together (so A and B point have to be on each other). K point will represent the production and consumption point of world before foreign trade and specialization. The process is quite similar to constant opportunity cost; the
12 only main difference is that specialization will not be complete. But both countries change their production structure, specialize for X or Y products, therefore the efficiency of their economies will increase, and they will be able to reach world production possibility frontier together. If the specialization happens similarly, the production and consumption point will move from K (suboptimal point) to L point. During the period of self-sufficiency, the slope of and line represents inner price ratios, after foreign trade and specialization we can draw a tangent on L point. The slope of this tangent shows us new price ratio. This price ratio is for the first and second country, and for world, too. Provision of specialization which improves the efficiency
of world-wide production is: ≠ .
1.7 SPECIALIZATION AND FOREIGN TRADE IN CASE OF INCREASING OPPORTUNITY COST FROM THE ASPECT OF RICARDO’S COMPARATIVE ADVANTAGES
Our previous examples were based on clear advantages and disadvantages, so they were better examples for Adam Smith’s theory. Now let us see the case of Ricardo’s comparative advantages; what happens if we do not have comparative advantages and disadvantages. Both countries can produce more X products than Y, but II. country can produce twice as much Y products than I. country but only 1.25th more X products. Which means that first country has comparative advantage in X products, while second country has comparative advantage in Y products. For any value of α following
inequality must be true: < .
13 6. Figure. Ricardo’s comparativ advantages
Source: Bock et. al., 1991.
Our next figure gives an example for a case when we cannot find comparative advantage or disadvantage between two countries. First country can produce less X and Y products. Second country owns absolute advantages in the production of X and Y products. From X products it can produce twice as much, and from Y products, too. So, the main provision of comparative
advantage is not met because the .
7. Figure. Lack of comparative advantages and disadvantages Source: Bock et. al., 1991.
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2. THE EFFECT OF PRODUCTION CONDITIONS ON FOREIGN TRADE
In previous chapter, we just used one factor of production, which was the labour. But even in the 18th century there was another factor of production which very important part of economy in the 19th century, this was the capital.
Capital means not only money capital but also fixed assets, machines, buildings, any equipment that is used in production. Some countries have more labour and less capital, some countries have more capital and less labour, this fact contributes to the creation of specialization possibility. Moreover, some products require more labour and less capital, while other product requires less labour and more capital. In this chapter, we examine trade and production based on two factors of production.
2.1 PRODUCTION FUNCTION AND TRANSFORMATION CURVE IN THE CASE OF CONSTANT RETURNS TO SCALE
Before we introduce our model, we need to pose some provisos. Firstly, both products are produced with constant returns to scale, which means that we have linearly homogeneous production function. (Main feature of this kind of function is that, if we increase the two factors of production with 1-1%, the volume of production increase with 1%, too. Secondly, one of the products (in our model X product) is capital-intensive, the other one is labour-intensive.
Thirdly, if we exclude the reversal of factor demand the isoquants of X and Y products intersect each other only once. Fourthly, we know the factor endowments of both countries.
15 8. Figure. Conditions of production for two products
Source: Bock et. al., 1991.
The figure represents two products, which requires capital and labour. Y product needs more capital, while X product needs more labour. In this economy, the maximum amount of Y product is 50 unit and in case of X product is 100 unit. Red lines show isocost line and we know from our microeconomic studies, that optimal combination of products are those points where an isocost line and isoquant curve meet with each other. (Isocost line shows those combinations of inputs which cost is the same; isoquant curve represents all factors (the quantities of factors change) which produce the same quantity of output).
In our models, we usually work with two countries, two products and two factors of production; therefore, we need a new tool to visualize it. This new tool is the Edgeworth-box, which can introduce two products and two factors in the same figure. The lower left-hand corner represents the origin for X products, while the upper right-hand corner represents the origin for Y products. From other aspect, the lower left-hand corner is equal with the maximum quantity of Y products, and the upper right-hand corner with the
16 maximum quantity of X products. In O point there is no Y production only X is produced (100 units) and in O’ point there is no X production only Y is produced (50 units). The diagonal represents those points where the factors of production are similar for X and Y products, too. The other problem with the diagonal is that isoquant curves (indifference curves) meet with each other twice on this level. Which is suboptimal, we would be able to increase the production of X or Y product. Furthermore, we know that X is labour-intensive, and Y is capital labour-intensive, so diagonal cannot be right. Therefore, we
16 maximum quantity of X products. In O point there is no Y production only X is produced (100 units) and in O’ point there is no X production only Y is produced (50 units). The diagonal represents those points where the factors of production are similar for X and Y products, too. The other problem with the diagonal is that isoquant curves (indifference curves) meet with each other twice on this level. Which is suboptimal, we would be able to increase the production of X or Y product. Furthermore, we know that X is labour-intensive, and Y is capital labour-intensive, so diagonal cannot be right. Therefore, we